Prime cut another .25%...

Surprised by depth of slump, central bank pegs rate at 0.25%

KEVIN CARMICHAEL

Globe and Mail Update

April 21, 2009 at 11:16 AM EDT

OTTAWA - The Bank of Canada cut its benchmark lending rate to the lowest possible, and promised to leave it there for as long as a year in order to fight a recession that is deeper and will last longer than previously thought.

The central bank on Tuesday dropped its key overnight target a quarter-percentage point to 0.25 per cent, which is "the effective lower bound" because anything deeper would disrupt short-term money markets, policy makers said in a statement.

In January, Bank of Canada Governor Mark Carney was counting on multibillion-dollar stimulus programs pledged by governments in the Group of 20 major economies to reverse the effects of the financial crisis by the third quarter of this year. Those policies are taking longer roll out than policy makers anticipated, a delay that's exacerbating the downturn.

"The global recession has intensified and become more synchronous since the bank's January Monetary Policy Report Update with weaker-than-expected activity in all major economies," the statement said. "While more aggressive monetary and fiscal policy actions are under way across the G20, measures to stabilize the global financial system have taken longer than expected to enact."

The central bank now predicts that Canada's gross domestic product will shrink by 3 per cent in 2009, compared with a January estimate for a 1.2-per-cent contraction.

The Bank of Canada also abandoned its relatively optimistic estimate that the economy would rebound to expand 3.8 per cent in 2010. The recovery will be far more muted, with an expansion of 2.5 per cent in 2010, the central bank said.

Mr. Carney and his chief advisers on the governing council are trying to restore confidence amid Canada's first recession since 1992. Employers have shed more than 270,000 jobs since the country fell into a recession in the fourth quarter, a period during which factories produced at only 75 per cent of their capacities, the lowest rate on record.

As troubling for the policy makers is an inflation rate that they said Tuesday will crater to an annual rate of negative 0.8 per cent in the third quarter.

The Bank of Canada is mandated by law to keep inflation advancing at a rate of about 2 per cent a year. That target won't be reached until the third quarter of 2011, the central bank said.

"Conditional on the outlook for inflation, the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010 in order to achieve the inflation target," the statement said.

That commitment is unusual for Canada's central bank, which typically is more circumspect in order to retain a degree of command over investors.

With the target rate at a bottom, Mr. Carney is being forced to pull back the curtain so investors better understand the trajectory of monetary policy.

By pledging to keep the benchmark rate low for a long time, policy makers are telling investors that they can safely price mortgage rates, corporate debt and other credit assets based on the 0.25 per cent target.

Without that certainty, investors might have been reluctant to lower longer rates.

"The Bank of Canada doesn't guarantee that it won't raise rates for a year, but its implicit message is that it sees that risk as very low given current economic slack," Avery Shenfeld, a senior economist at the CIBC World Markets, said in a note to clients.

Many analysts said before Tuesday's release that they thought Mr. Carney would leave the overnight target unchanged to avoid the technical headaches of adjusting a rate that was already so close to zero.

The overnight target is the rate at which the Bank of Canada encourages financial institutions to lend to each other at the end of the day when they settle their accounts.

Ultimately, commercial lenders who need either a short-term loan or a place to park excess funds at the end of the day can turn to the central bank. To encourage private institutions to balance these funds themselves, they charge 0.25 per cent more than the target on loans, and pay 0.25 per cent below the target on deposits.

Tuesday's decision makes the target and the deposit rate one and the same.

The Bank of Canada left the deposit rate unchanged at 0.25 per cent because a rate of zero would have made lending in short-term money markets unprofitable.

 

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